Definition of 'Fisher Effect'

An economic theory proposed by economist Irving Fisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation.

Investopedia explains 'Fisher Effect'

The Fisher effect can be seen each time you go to the bank; the interest rate an investor has on a savings account is really the nominal interest rate. For example, if the nominal interest rate on a savings account is 4% and the expected rate of inflation is 3%, then money in the savings account is really growing at 1%. The smaller the real interest rate the longer it will take for savings deposits to grow substantially when observed from a purchasing power perspective
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Definition of 'International Fisher Effect - IFE'

An economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time. Calculated as:

Where: "E" represents the % change in the exchange rate "i1" represents country A's interest rate

"i2" represents country B's interest rate

Investopedia explains 'International Fisher Effect - IFE'

For example, if country A's interest rate is 10% and country B's interest rate is 5%, country B's currency should appreciate roughly 5% compared to country A's currency. The rational for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate. This increased amount of inflation should cause the currency in the country with the high interest rate to depreciate against a country with lower interest rates. Read more: http://www.investopedia.com/terms/i/ife.asp#ixzz1monOZRjd

The International Fisher Effect: An Introduction

The International Fisher Effect (IFE) is an exchange rate model designed by the economist Irving Fisher in the 1930s. It is based on present and future risk-free nominal interest rates rather than pure inflation, and is used to predict and understand present and future spot currency price movements. In order for this model to work in its purest form, it is assumed that the risk-free aspects of capital must be allowed to free flow between nations that comprise a particular currency pair. Fisher Effect Background The decision to use a pure interest rate model rather than an inflation model or some combination stems from the assumption by Fisher that real interest rates are not affected by changes in expected inflation rates because both will become equalized over time through market arbitrage; inflation is embedded within the interest rate and factored into market projections for a currency price. It is assumed that spot currency prices will naturally achieve parity with perfect ordering markets. This is known as the Fisher Effect and not to be confused with the International Fisher Effect. (To learn more about interest rate models and how they relate to currency, check out Forex Tutorial: Economic Theories, Models, Feeds And Data.) Fisher believed the pure interest rate model was more of a leading indicator that predicts future spot currency prices 12 months in the future. The minor problem with this assumption is that we can't ever know with certainty over time the spot price or the exact interest rate. This is known as uncovered interest parity. The question for modern studies is: does the International Fisher Effect work now that currencies are allowed to free float. From the 1930s to the 1970s we didn't have an answer because nations controlled their currency price for economic and trade purposes. This begs the question: has credence been given to a model that hasn't really been fully tested? Yet the vast majority of studies only concentrated on one nation and compared that nation to the United States currency. Free Currency Trading eBook From Forex.com The Fisher Effect Vs. The IFE The Fisher Effect model says nominal interest rates reflect the real rate of return and expected rate of inflation. So the difference between real and nominal rates of interest is determined by expected rates of inflation. The approximate nominal rate of return = real rate of return plus the expected rate of inflation. For example, if the real rate of return is 3.5% and expected inflation is 5.4 % then the approximate nominal rate of return is 0.035 + 0.054.= 0.089 or 8.9%. The precise formula is (1 + nominal rate) = (1 + real rate) x (1 + inflation rate), which would equal 9.1% in this example. The IFE takes this example one step further to assume appreciation or depreciation of currency prices is proportionally related to differences in nominal rates of interest. Nominal interest rates would automatically reflect differences in inflation by a purchasing power parity or no-arbitrage system.

The IFE in Action For example, suppose the GBP/USD spot exchange rate is 1.5339 and the current interest rate in the U.S. is 5% and 7% in Great Britain. The IFE predicts that the country with the higher nominal interest rate (GBP in this case) will see its currency depreciate. The expected future spot rate is calculated by multiplying the spot rate by a ratio of the foreign interest rate to

domestic interest rate: (1.5339 X (1.07/1.05) = 1.5631. The IFE expects the GBP/USD to appreciate to 1.5631 and the USD/GBP to depreciate to 0.6398 so that investors in either currency will achieve the same average return i.e. an investor in USD will earn a lower interest rate of 5% but will also gain from appreciation of the USD.

For the shorter term, the IFE is generally unreliable because of the numerous short-term factors that affect exchange rates and the predictions of nominal rates and inflation. Longer-term International Fisher Effects have proven a bit better, but not by very much. Exchange rates eventually offset interest rate differentials, but prediction errors often occur. Remember that we are trying to predict the spot rate in the future. IFE fails particularly when the costs of borrowing or expected returns differ, or when purchasing power parity fails. This is defined when the cost of goods can't be exchanged in each nation on a one-for-one basis after adjusting for exchange rate changes and inflation. (Learn about one metric used to gauge price parity between nations in Hamburger Economics: The Big Mac Index.) Conclusion Today, we don't normally see the big interest rate changes we have seen in the past. One point or even half point nominal interest rate changes rarely occur. Instead, the focus for central bankers in the modern day is not an interest rate target, but rather an inflation target where interest rates are determined by the expected rate of inflation. Central bankers focus on their nation's Consumer Price Index (CPI) to measure prices and adjust interest rates according to prices in an economy. To do otherwise may cause an economy to fall into deflation or stop a growing economy from further growth. The Fisher models may not be practical to implement in your daily currency trades, but their usefulness lies in their ability to illustrate the expected relationship between interest rates, inflation and exchange rates.

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